Pages

Friday, December 23, 2016

My latest Macro Musings podcast is a special holiday edition on the economics of Christmas.Two special guests joined me all the way from Germany to discuss this topic. My first guest was Anna Goeddeke, a professor of economics at ESB Business School in Reutlingen, Germany. My second guest was Laura Birg, a postdoctoral researcher at the Center for European, Governance, and Economic Development Research, University of Göttingen

Together they coauthored an article in Economic Inquiry titled “Christmas Economics—a Sleigh Ride” that surveys and summarizes the economics literature on Christmas. It is a great read for this time of the year and was the basis of our conversation. We touched on a number of interesting topics like the seasonal business cycle, the deadweight loss of Christmas, and charitable giving during the holidays.

The seasonal business cycle discussion was particularly fascinating for me. There is a literature that starts with Barksy and Miron (1989) (ungated version) that shows most of the variation in aggregate economic measures like GDP comes from seasonal fluctuations. Yet most macroeconomists, myself included, typically start our analysis with seasonally-adjusted data. Here is a Barky and Miron summarizing their findings on GDP for 1948:Q2-1985:Q5:

The standard deviation of the deterministic seasonal component in the log growth rate of real GNP is estimated to he 5.06%, while that of the deviations from trend is estimated to be 2.87%. Deterministic seasonal fluctuations account for more than 85% of the fluctuations in the rate of growth of real output and more than 55% of the (percentage) deviations from trend. Business cycle fluctuations and/or stochastic seasonal fluctuations represent a relatively small percentage of the fluctuations in real output. Plots of the log level of real output (Figure 1) and the log growth rate of real output (Figure 2) make this point even more clearly. The seasonal fluctuations in output are so large and regular that the timing of the peak or trough quarter for any year is rarely affected by the phase of the business cycle in which that year happens to fall.

Unfortunately, the BEA no longer makes available non-seasonally adjusted GDP data. However, we can look at other times series to see how large seasonal swings can be relative to recessions. For example, below is retail sales:

What makes this really interesting is that these wide swings in economic activity are not matched by similarly-sized swings in the price level. Most of the seasonal boom is in real activity. Put differently, there is an exogenous demand shock every fourth quarter where prices remain relatively sticky so real activity surges. This is a microcosm of demand-side theories of the business cycle. It seems, then, that more could be learned about broader business cycle theory from studying GDP and other time series in their raw non-seasonally adjusted form. That will have to wait, however, until the BEA starts releasing the data.

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming.

Monday, December 19, 2016

One more quick note on the Trump shock and interest rates. For some time I have been following the global safe asset shortage problem and how it has created a downward march of safe assets interest rates. This can be seen in the figure below:

The latest development in this story is that the safe asset interest rates have all started heading up, as seen in the above figure. Even Japan's which is supposed to be targeted at 0 percent but has climbed to 0.8 percent. Now these yields have a long ways to go before reaching normal levels and they started rising before Trump's election. But since the election the ascension of these interest rates has accelerated in many cases. This is a bit puzzling. It is one thing to think the Trump shock has changed the growth and inflation outlook in the United States so that treasury yields are now going up, but why the other advanced economies?

As you may recall, the safe asset shortage story says there has been a price floor (ceiling) on safe asset interest rates (bond prices) that has kept the market for safe assets from properly clearing. (See this pre-2008 figure and post-2008 figure for a graphical representation of this story.) The shortage was a big deal because these securities functioned as transaction assets for institutional investors. The shortage, therefore, amounted to an effective shortage of money that was evident in the below trend growth of broad monetary aggregates that measure both retail and institutional money assets.

There were there three solution paths that could solve this problem: increase the supply of safe assets, decrease the demand for safe assets by improving the economic outlook, or do negative interest rates. These three paths are depicted below:

The Trump shock seems to be working through the first two options for U.S. treasuries. First, the Trump infrastructure plans and tax cuts imply larger budget deficits. Second, the spending and supply-side reforms suggest an improved economic outlook that is decreasing demand for treasury securities. This story, though, only explains the U.S. situation.

What is puzzling is why the Trump shock seems to be causing foreign safe assets yields to rise. Maybe it is the reverse of the Caballero, Fahri, Gourinchas (2016) story that says shortage of safe assets problem will spread from one country to another. That is, the easing of safe asset pressures in the United States is causing an easing of safe asset pressures elsewhere. But that story runs up agains the potential global economic downside from a stronger dollar that will result from a stronger U.S. economy. So I am left a bit puzzled.

Friday, December 16, 2016

I have a new piece in The Hill where I argue markets are increasingly seeing the Trump shock as an inflection point for the U.S. economy:

It seems the U.S. economy is finally poised for robust economic growth, something that has been missing for the past eight years. Such strong economic growth is expected to cause the demand for credit to increase and the supply of savings to decline

Together, these forces are naturally pushing interest rates higher. The Fed’s interest rate hike today is simply piggybacking on this new reality.

Here are some charts that document this upbeat economic outlook as seen from the treasury market. The first one shows the treasury market's implicit inflation forecast (or "breakeven inflation") and real interest rate at the 10-year horizon. These come from TIPs and have their flaws, but they provide a good first approximation to knowing what the bond market is thinking. In this case, both the real interest rate and expected inflation rate are rising. This implies the market expects both higher real economic growth and higher inflation. The two may be related--the higher expected inflation may be a reflection of higher expected nominal demand growth causing real growth. The higher real growth expectations are also probably being fueled by Trump's supply-side reforms.

The next figure shows the New York Fed's decomposition of the 10-year treasury into the term premium and a 'risk-neutral' nominal interest rate. Both have gone up since Trump's election. The term premium going up can be seen as investors being less risk averse and therefore demanding higher compensation for holding longer-term safe asset-bonds. The risk-neutral part can be seen as a product of the real interest rate and the expected inflation. And, as we saw in the first figure above, they are both growing:

These figures, as well as the surge in the stock market, indicate the markets see more robust growth ahead. Given the timing of these surges, the figures seem to attribute the improved economic outlook largely to the Trump shock.

Now markets may be getting ahead of themselves, but if these expectations come to fruition there is another big lesson to be learned from the Trump shock:

One of the big lessons from this rate decision is that the Fed cannot sustainably push up interest rates through the brute force of monetary policy. Rather, interest rates have to be pulled up by robust economic growth with the Fed following suit.

This understanding also means the Fed did not push interest rates to zero percent in late 2008. Rather, it followed the collapsing market forces that were pulling interest rates down at the time.

To the extent the Fed wants a stable economy, it is limited in how much it can adjust interest rates. Its interest rate adjustments have to follow the health of the economy.

Luckily for the Fed, the health of the U.S. economy seems to have turned the corner and begun a robust recovery. This has allowed the Fed to finally break free from the chains of low interest rates.

My latest Macro Musings podcast is special one where we look at the macroeconomics of Star Wars and Star Trek. We do so with the help of two guests who are experts on the economics of these two scifi franchises. [Update: sound quality starts out poor, but gets better a few minutes into the show.]

Our first guest is Zachary Feinstein. Zach is an assistant professor at Washington University in St. Louis and the author of a study titled "It's a Trap: Emperor Palpatine's Poison Pill" where he provides a fascinating look at the financial consequences of the destruction of the second death star. This article received a lot of media coverage last year when Star Wars: the Force Awakens came out. For example, below is a screen shot from a Bloomberg interview discussing the financial burden of building the two death stars. Now with the release of Star Wars: Rogue One upon us it was only fitting to have him join the show and share with us his knowledge of the economics of Star Wars.

Our second guest is Manu Saadia. Manu is a writer based in Los Angeles and a lifelong Trekkie. He published this year titled Trekonomics: the Economics of Star Trek which is a must read for any serious Trekkie. The book was hailed by Nobel Laureate Paul Krugman as "the book on the topic". This book too has received a lot of mediaattention. One reason for its popular reception is that book wrestles with many of the issues now facing advanced economies as they become increasingly automated and run by smart networked machines. Below is the cover of the book.

This was super fun conversation. We started out discussing the basic economic institutions--money, interplanetary trade, trade, labor specialization, taxes, banking systems, etc-- of Star Wars and Star Trek. We next turned to business cycle issues--the destruction of the second death start created the mother of all depression--and then to the long-run economic growth in both scifi universes. We concluded by considering the implications from these franchises for us today.

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming.

Our conversation begins with what Peter calls the three foundings of the Fed: 1913, 1935, and 1951. These were the pivotal dates where major changes were made in the legal structure of the Fed. These changes, however, only changed the legal infrastructure to the Fed. Important personalities continued to transform the institution. Peter points specifically to three Fed chairs for making the Fed what it is today: William McChesney Martin, Paul Volker, and Allan Greenspan.

We also cover the important role the staff plays at the Fed. In particular, the discuss the inordinate influence the head of the international finance division and the general counsel play in shaping international and domestic policy. That they have so much power, but are not appointed creates legal issues according to Peter. Similarly, regional bank presidents are FOMC members who set national policy but not appointed by the President. Peter believes a reexamination of how they are appointed is warranted too.

We then discuss some more recent issues such as the debate over whether the Fed was really constrained by law when it came to bailing out Lehman. Peter, a lawyer, provides a discussion of this legal claim made by Fed officials and does not find it convincing.

Finally, we talk about the future of the Fed under President Trump. One question we consider is whether the President can fire a Fed chair. President Truman fired Thomas McCabe and there enough legal ambiguity that it could be done again. But it would be politically costly. We also discuss who would be on the shortlist for the board of governor positions for Donald Trump.

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming.

Friday, December 2, 2016

One of the big questions going into 2017 is how resilient the global economy will be to a further strengthening of the dollar. The Trump shock and the Fed's desire to raise interest rates almost guarantee a strengthening of the dollar next year. Unfortunately, this is not the best time for a surging dollar since the global economy is ripe with dollar-denominated debt and anemic growth.

The dollar's initial surge took place between mid-2014 and late 2015 when it grew over 20 percent. This sharp rise was tied to the Fed talking up interest rate hikes while the ECB signaled lower future interest rates. The figure above shows this by reporting the spread between the U.S. and Eurozone 6-month interest rate, 6 months ahead along with the trade-weighted dollar. The figure shows that after plateauing for much of 2016--with some bumps along the way--the dollar has recently started strengthening again as the spread has started to widen. My concern is that this will continue into 2017.

It is instructive to look closer at the dollar surge in 2014-2015 to get sense of what could happen in 2017. For this initial dollar growth explains a lot of developments in the global economy over the past couple of years.

First, it explains the timing of the financial stress of late 2015 and early 2016. By that period the value of the dollar had reached a point where it caused the financial imbalances in China to start cracking. Those financial stresses temporarily spread to stock markets around the globe.

Second, it also explains why China allowed its currency to devalue, as I suscepted would happen. China was violating the macroeconomic trilemma and could only do so for so long. The stronger dollar forced the hand of the Chinese monetary authorities who have been allowing a moderate devaluation of their currency this year. Now that the dollar is strengthening even more, the capital outflows are increasing in anticipation of further devaluation of the renminbi. And no, I do not think capital controls will solve the problem.

Third, it explains why the Fed has been stuck in a seemingly endless rate-hike-talk-loop-cycle in 2016. The cycle goes something like this: the Fed talks up interest rate hikes → dollar begins to strengthen → bad economic news emerges → the Fed dials down its rate hike talk → dollar pressures ease → good economic news emerges → repeat cycle. This cycle occurs because one, there is approximately $10 trillion in dollar-denominated debt outside the United States per the BIS and two, because many countries still peg to the dollar. A strengthening dollar is a problem for the former since implies a higher debt burden while for the latter it means pegging countries have to import the Fed's tightening of monetary policy. Most Fed officials, other than Governor Lael Brainard, fail to fully appreciate this loop.

Fourth, it explains a sizable part of oil's decline since 2014. Both Ben Bernanke and Jim Hamilton estimated that about 40-45 percent of oil's decline this time is because of weakened global demand. Following similar methods, I estimated it to be about 50 percent. Of course, this begs the question as to what caused global demand to weaken. The obvious candidate was the strengthening dollar putting a chokehold on global economic growth.

Going into 2017 these same dynamics are likely to intensify if market forecasts are correct. Both the stock market and bond market see improved economic growth ahead from the Trump shock. Along with this growth, however, will come higher interest rates and a stronger dollar. So while the U.S. economy seems geared to take off in 2017, the global economy seems positioned to sputter as it faces a stronger dollar. If that sputtering turns into an outright stall then all bets are off for the Fed tightening next year.

Tuesday, November 29, 2016

The Mercatus Center is running a colloquium on the low interest rate environment and its implications for the economy. The colloquium runs twelve days and each day a new essay will be published. Since this is leading up to the holidays, some are calling it the "twelve days of interest".

Today the colloquium ran my essay in which I make the case that the 10-year treasury interest rate will return to the range of 4.0 to 4.5 percent. This definitely goes against the conventional view that the natural interest rate or "r-star" has permanently fallen and will keep treasury yields depressed. This view is evident, for example, in the FOMC's summary of economic projections (SEP) where members expect the long-run value of the federal funds rate to land near 3 percent. So why my contrarian claim?

My answer, as laid out in the piece, is that much of decline in the 10-year real interest rate is due to a temporary decline in the natural interest rate. In my view, this decline is tied to business cycle forces rather than structural ones. As evidence for my view, I provide Figure 5 which shows a strong relationship between the natural interest rate--the 10-year, risk-free, real interest rate in the article--and the CBO's output gap. Here is the same data plotted in a scatter plot:

And here is the output from running a regression on these two series:

As I note in the piece, these results imply that if the output gap eventually closes (i.e. goes to zero) the natural interest rate will hit 1.65 percent. Add in 2 percent for inflation and a modest amount for the term premium and one easily breaks the 4.0 percent barrier.

I may be proved wrong, but the early bounce from the Trump shock is pushing in my direction. To be upfront, though, I was making a similar argument in 2014 when the economy early on appeared to be taking off. I still think my call was reasonable given robust growth in early 2014, but the growth quickly got snuffed out. It did so, in my view, because the Fed began talking up interest rate hikes and effectively tightening policy in mid-2014. Throw in some strains on the term premium from problems in China, Eurozone, new regulatory burdens and you get the low treasury yields since 2014. This seems to be changing now with the Trump shock but we will have to wait to know for sure.

I encourage you to keep following the colloquium. Other contributors, often with less sanguine views about future interest rates, will follow. The next one, for example, is from Joe Gagnon who does not share my outlook on interest rates. Also, the other pieces that follow will get more into the implications of the low interest rate environment. So stay tuned!

Monday, November 28, 2016

My latest Macro Musings Podcast is with JP Koning. JP is an economist who works in the Canadian financial industry and is a walking encyclopedia on the institutional details of central banks and money. He runs a fantastic blog called Moneyness--a must read for anyone serious about understanding money and its history. JP joined me to talk about some of the more interesting institutional arrangements for central banks and money today.

We began our conversation by talking about central banks of Switzerland, Japan, South Africa, Belgium, and Greece. They are unique in that they have stocks that are traded on the stock market. As JP notes, however, these stocks function more like a perpetual bond than an actual stock.

Another fascinating central bank story is that the Bank of England in that it used to allow personal checking. It no longer does this, but it demonstrates that the current restrictions on access to central bank balance sheets has not always been in place. And there are many advocates who would like to see a further openness of central bank balance sheets as a way to stem financial crisis. We discuss the implications of going down this path.

What happens when a central bank has internal divisions and various branches compete against each other? This happened recently in Libya and JP gives us the details. Our conversation then turned to the dollarization of the Zimbabwe economy following its bout of hyperinflation in 2008. We discuss how it happened and the influence U.S. monetary policy has on dollarized economies. We also discuss what appears to new monetary mischief being done by the government of Zimbabwe.

We also briefly touch on the latest case of hyperinflation in Venezuela. The Wall Street Journal had an interesting piece on a man who is considered by the number one nemesis of the Venezuela government for publishing black-market exchange rate of the Bolivar currency.

Our talk ends with a discussion on the Fedwire and the potential for a Fedcoin.

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming.

P.S. Here is a slide show on the evolution of Zimbabwe's currency leading up to the hyperinflation in 2008.

Friday, November 25, 2016

My latest Macro Musings podcast is with Mark Calabria of the Cato Institute. We discussed his time doing financial regulation and Fed policy as a senior staffer on the U.S. Senate Committee on Banking, Housing, and Urban Affairs. We also spent some time discussing his new paper on applying behavioral economics to Fed policy.

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming.

This was a very fascinating conversation. Roger makes the case that modern macroeconomics as it is formally practiced has gone down the wrong path with the New Keynesian paradigm. He considers it a degenerative research agenda for several reasons. First, it is premised on the natural rate hypothesis (NRH) which he sees as incorrect. He uses the analogy of a child hitting a rocking horse to describe the NRH. The child hitting the horse will cause it to rock, but eventually it will come to rest. Likewise an economy buffeted by shocks will cause fluctuations but eventually the economy will return to its full employment level. Roger sees this view as fundamentally wrong

Roger contends a more accurate analogy would be a rudderless boat blown by various winds to new locations and staying there until new winds come along. Put differently, Roger believes in multiple equilibria for the economy that arise because of various shocks--the winds--pushing the economy to new points. The economy may stay at these equilibria for some time. Some equilibria may be good, some bad. One of the important shocks that determine these equilibria are peoples beliefs or confidence. In his work he has formally modeled this through a 'belief function' that replaces the Philips Curve in the standard New Keynesian model. This was a key theme running throughout our conversation.

Other problems Roger sees with the New Keynesian paradigm include prices being implausibly sticky, the absence of involuntary unemployment, small welfare costs to business cycles, and the inability to explain bubbles and crashes. His modeling approach aims to fix these problems and bring back the original animal spirit theme of Keynes in a formal rational expectations framework.

Moving beyond modeling issues, Roger also believes the reason for economic volatility is not sticky prices but incomplete markets. Specifically, incomplete labor and financial markets. This was interesting because it implies price signals are not working properly and preventing markets from doing their magic. His solution is to have the government stabilize the growth of a stock market index via purchases of ETFs.

This was a fun conversation throughout. And his book is highly recommend. It really gets into the philosophy of science and its implications for the macroeconomic discipline.

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can

also listen via the embedded player above. And remember to subscribe since more shows are coming.

Tuesday, November 8, 2016

Back in September I was part of the Monetary Policy Rules for a Post-Crisis World conference. It was jointly hosted by the Mercatus Center and the Cato Institute. There were many interesting presentations from folks like David Laidler, Perry Merhling, Robert Hetzel, Miles Kimball, Peter Ireland, John Taylor, and Scott Sumner. The panel moderators--Ylan Q. Mui, Ryan Avent, Cardiff Garcia, and Greg Ip--were great too!

I wanted to share the working paper I presented at the conference. It was titled The Fed's Dirty Little Secret and now is posted online. This paper had its origins in an earlier blog post of mine. It was fun taking an idea sketched out on this blog and turning into a paper. Below is the paper's abstract:

Despite the Federal Reserve’s use of QE programs, the U.S. economy experienced one of the weakest recoveries on record following the Great Recession. Not only was real growth disappointingly low, but even nominal growth over which monetary policy has more control was feeble. Why did QE fail to stimulate robust aggregate demand growth? This paper argues the answer is that the Federal Reserve could not credibly commit to a permanent expansion of the monetary base under QE. Both the quantity theory of money and New Keynesian theory show, however, that a permanent expansion of the monetary base is needed to spur aggregate demand growth at the ZLB. The Federal Reserve’s inability to do so meant its QE program got consigned to ‘irrelevance results’ of Krugman (1998) and Eggertson and Woodford (2003) and were never going to spark a strong a recovery. This is the Fed’s dirty little secret. Moving forward, this inability to commit to permanent expansions of the monetary base at the ZLB will continue to weigh down on the effectiveness of Fed policy. As a result, this paper calls for a new monetary policy regime of a NGDP level target that is backstopped by the U.S. Treasury Department.

Monday, November 7, 2016

My latest Macro Musings podcast is with Mark Koyama. Mark is an assistant professor of economics at George Mason University where he specializes in economic history, the roles institutions play in economics, and how culture and economics interact. Mark recently has recently written on the macroeconomics of ancient Rome and he joined me to talk about it.

This was a super fascinating conversation where we cover the history of Rome, the extent and depth of markets in ancient Rome, and the long-run growth prospects of Rome. We also discuss the the extent to which credit and financial markets were developed in Rome, including the well-documented financial panic of 33 AD that affected various part of the empire.

Part of our conversation was motivated by Peter Temin's book The Roman Market Economy. Apparently, some ancient historians have had a hard time accepting the premise of a market economy in Rome. Peter Temin book pushes back against this view drawing upon economics, other recent work, and archaeological evidence. The evidence increasingly points to an integrated market economy that existed throughout the empire.

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming.

Monday, October 31, 2016

My latest podcast is with Rudiger Bachmann. Rudi is an associate professor of economics at the University of Notre Dame and a research affiliate at the Center for Economic Policy Research. Rudi has published widely on macroeconomic issues in top journals and is an active member of the German Economic Association. He also blogs and write popular press articles for the German media. Rudi joined me on the show to discuss German macroeconomics as well as some of his own research.

Our conversation begins by noting that German macroeconomics appears to be very different than Anglo-American macroeconomics. Rudi notes that is partly a misperception problem, but there is indeed something different. What is different is how macroeconomics is currently practiced in Germany: it reflects the ordoliberalism view that stresses a rules-based approach to policy. This approach to macroeconomics makes lawyers rather than economists top advisers to policy in Germany and it reflects the lasting legacy of Walter Eucken. This view not only affects Germany, but macroeconomic policy throughout the EU.

One of the interesting issues that emerge from this discussion is that the German polity seems to worry more about repeating the mistakes of the Weimar hyperinflation in the early 1920s than the mistakes of the Great Depression in the late-1920s. The former is well known but the latter was arguably more consequential since it helped bring the Nazi to power in Germany. It is not clear why the hyperinflation experience trumps the Great Depression experience, but its experience helps shape the ordoliberalism approach to economic policy in Europe today.

Rudi and I then shift our conversation to the future of Europe. Rudi remains hopeful that EU project will survive the Eurozone crisis and other challenges now facing it.

We conclude by discussing Rudi's work on uncertainty and the business cycle and the importance of inflation expectations for consumers.

This was a fascinating conversation throughout.

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming.

Sunday, October 30, 2016

Bloomberg is reporting that Zimbabwe might be up to some monetary mischief again. The government has started printing currency and, as first notedby JP Koning, the way they are doing it seems dubious. So, as a reminder to the government of Zimbabwe, it might be wise to revisit how bad the monetary mischief got back in 2008. You do not want to repeat that experience.

Steve Hanke found the monthly inflation rate hit 79.6 billion percent in November 2008 (89.7 sextillion percent on a year-on-year basis). That is how bad it got. This bout of hyperinflation began in early 2007 and ended in late 2008. At that point the government shut down the printing presses and allowed its citizens to freely use foreign currency. The country quickly dollarized and the country once again had a stable medium of exchange.

One way to visualize this hyperinflation is to look at the progression of currency printed by the government. Below are some slides I put together that shows this development. It is interesting to observe that in early 2007 Zimbabwe had similarly sized dollar notes to those in the United States. That quickly changed as prices began exploding.

So take note Zimbabwe. Let's not repeat the painful experience of 2007-2008.

P.S. What would happen to places like Zimbabwe if Ken Rogoff's proposal to eliminate U.S. gained traction?

Friday, October 28, 2016

I have a new working paper with Josh Hendrickson titled Nominal GDP Targeting and the Taylor Rule on an Even Playing Field. Using a standard New Keynesian model, Josh and I show one of the advantages of a nominal GDP target is that it is more robust to the knowledge problem facing central bankers than is the standard approach that implicitly invokes some kind of Taylor rule.

Here is an excerpt from the paper on the knowledge problem:

One of the key challenges facing monetary policy authorities is the knowledge problem. As first noted by Hayek (1945), this problem arises because the information needed for optimal economic planning is distributed among many individual firms and households and therefore outside the knowledge of a central planning authority. This observation, when specifically applied to central banking, means that the information required to make activist countercyclical policies work is not available. Consequently, monetarists like Friedman (1953, 1968), Brunner (1985), and Meltzer (1987) argued early on against central bank discretion and instead called for simple rules that committed monetary authorities to stable money and nominal income growth.

The knowledge problem was later shown by Orphanides (2000, 2002a, 2002b, 2004) to apply not only to central banks that conduct discretionary monetary policy but also to ones that follow a “constrained discretionary” approach to monetary policy. That is, even central banks that follow some kind of Taylor rule in a flexible inflation-targeting regime are susceptible to the knowledge problem...

The biggest information challenge comes from attempting to measure the output gap in real time. The output gap is the difference between the economy’s actual and potential level of output and is subject to two big measurement problems. First, real-time output data generally get revised and often on the same order of magnitude as the estimated output gap itself. Second, potential output estimates are based on trends that rely on ever-changing endpoints. Orphanides finds the latter problem to be the biggest contributor to real-time misperceptions of the output gap. This means that even if real-time data improved such that there were fewer revisions, there would still be a sizable problem measuring the real-time output gap.

To illustrate these problems, figure 1 replicates Orphanides’s (2002b) construction of real-time output gap measures using vintage real output data and compares them to final output gap measures using the Hodrick-Prescott and Baxter-King filters…

The top panel in figure 1 shows both the real-time and final output gap measures. To help discern how different these measures are, the second row plots the real-time output gap misperceptions, or the difference between the real-time and final output gaps. Both the HodrickPrescott and the Baxter-King filters reveal sizable measurement problems, particularly in the 1970s. The Hodrick-Prescott filter shows real-time output gap misperceptions reaching as much as 5 percentage points, while the Baxter-King filter shows up to 2 percentage points in the 1970s.

Orphanides (2004) sees these large measurement errors as a key contributor to the unmooring of inflation in the 1970s. He shows that, if the real-time estimates of the output gap and inflation from the 1970s are plugged into a Taylor rule like equation... the result is pretty close to the actual monetary policy that occurred during this time. The Great Inflation, in other words, was not the result of the Federal Reserve failing to properly respond to the economic developments of the time. It was the result of the Federal Reserve failing to properly measure the output gap.

Interestingly, figure 1 also indicates that the Great Moderation period of 1984–2007 was characterized by relatively smaller real-time output gap misperceptions. These findings raise questions about the claims of Taylor (1999), Clarida, Galí, and Gertler (2000), and others who see the Federal Reserve’s Federal Open Market Committee after Chairman Paul Volker’s term as more disciplined in its response to inflation. They suggest, instead, that Walsh (2009, 216) may be correct in his assessment that the success of targeting inflation has more to do with the “good luck” coming from a “benign economic environment” than from improved monetary policy.

Monday, October 24, 2016

My latest Macro Musings podcast is with Narayana Kocherlakota. Narayana is a professor of economics at the University of Rochester. He has published widely in economics, including in the areas of money and the payment system, business cycles, financial economics, public finance, and dynamic contracts. He also writes regularly for Bloomberg View.

Formerly, Narayana was the president of the Minneapolis Federal Reserve bank, where he served between 2009 and 2015. He joined me to talk about his time at the Fed and his current views on Fed policy.

This was a fascinating conversation throughout and a must-listen episode for all Fed watchers. The first part of our conversation covered what it was like being a regional Fed president. This included, among other things, how he stayed informed, how he managed the Minneapolis Fed, and how he prepared for FOMC meetings.

We then moved onto the the FOMC and the dynamics of the meeting itself. The preparation, the room, the seating, the order of business, and the rules of engagement are all important part of the FOMC decision-making process, but also are little known to outsiders. Narayana fills us in on the details as we discuss these and other issues--including whether FOMC members are more guarded in what they say because transcripts will be released--surrounding the FOMC meeting.

Our conversation next turned to the actual conduct of monetary policy since the crisis. What role did the Fed policy play in the recovery? Could it have done more? If so, was a more aggressive monetary policy even possible? Also, to what extent did public pressure play on shaping Fed policy versus the internal thinking of FOMC members themselves.

Finally, we discuss ways to improve Fed policy and whether the supply side of the economy is endogenous, in part, to demand pressures. This was a great conversation.

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming.

Monday, October 17, 2016

My latest Macro Musings podcast is with Izabella Kaminska. Izabella is part of Financial Times Alphaville, where she has been since 2008. She has written extensively on monetary policy, fiscal policy, financial technology, and is key force behind the Financial Times Festival of Finance. As a longtime follower of her work, it was a real treat to have her on the show.

We started our conversation by talking about blockchain technology and its implications for the payment system. Izabella is not optimistic about blockchain's future and wonders whether it will fulfill the expectations and hopes many observers have set out for it.

Next, we move on to the topic of universal banking. This is the idea that a central bank would open its balance sheet to anyone, including households and non-financial businesses. Doing so would solve the bank run problem and reduce the probability of a financial crisis. There are already movements in that direction with introduction of the Fed's overnight reverse repo program (RRP) and derivative houses opening accounts with the Chicago Fed. In the limit, universal banking would mean individuals could have personal checking accounts at the Fed. While this might solve the bank run problem, it would also mean a much larger government role in financial intermedation. We discuss why this would probably end very badly.

Izabella then discusses her take on unconventional monetary policy, especially the use negative interest rates. She is very critical of negative interest rates and explains why. Our conversation then segues into what can be done by policymakers during a deep recession.

We conclude by taking a look at the book Trekonomics, by Manu Saadia, and consider its implications for future of economic growth. We also spend some time comparing the economics of Star Trek to Star Wars.The conversation was fascinating throughout.

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming.

Monday, October 10, 2016

My latest Macro Musings podcast is with Claudio Borio. Claudio is the director of the Monetary and Economic Department at the Bank for International Settlements (BIS) and has been at the BIS in various roles since 1987. Previously, he was an economist with the OECD. Claudio is the author of numerous publications in the fields of monetary policy, banking, finance and issues related to financial stability. He is a leading voice on macroprudential regulation as well on international monetary stability issues. Claudio joined me to talk about these and other issues.

We began our conversation by considering what it is like to work at the BIS, the banks for central banks. We then segue to a discussion on the period leading up to the Great Recession, a time when the BIS was one of the few institutions warning about the credit and housing boom. How did they get it right when so many central banks got it wrong? One answer is the BIS perspective on macroeconomics goes beyond the standard took kit of interest rates, inflation, and output gaps. The BIS, for example, does not see price stability as a sufficient condition for financial stability, it looks at gross capital flows rather than net, and it closely follows excessive credit growth. This thinking was largely absent from central banks prior to 2008.

Our conversation next moved to the international monetary system, the outsized role the dollar and the Fed plays in it, the Triffin dilemma, and what can be done to make the global financial system more robust.

Claudio gave an interesting talk late last year title Revisting the Three Pillars of Monetary Policy. The three pillars are the importance of the equilibrium interest rate, the long-run neutrality of monetary policy, and the need to avoid deflation in all circumstances.We discuss why a more nuanced understanding of these ideas is needed and how it may have produced better macroeconomic policy before the crisis. For example, Claudio notes that this understanding would have made it easier to avoid the 'debt trap' that much of the global economy seems to be stuck in at the present. It also would have made central banks less fearful of benign deflationary pressures--those created by positive supply shocks--and thus avoided unnecessarily easy monetary policy during the housing boom period.

We then consider Claudio's coauthored article that reviews the vast amount of research that has been done on estimating the effect of the various unconventional monetary policies tried since the Great Recession. Claudio's survey of the literature finds that these policies have influenced yields and asset prices, but their effect on the real economy is more uncertain.

Finally, we close by asking Claudio what advice he would give to a young, budding macroeconomist. It was a fascinating conversation throughout.

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming.

Monday, October 3, 2016

My latest Macro Musing podcast is with Andrew Levin. Andy is a professor of economics at Dartmouth College and previously served two decades as an economist at the Federal Reserve Board, including two years as a special adviser to Chairman Ben Bernanke and Vice Chair Janet Yellen. Andy, in short, has a deep understanding of the history and workings of the Board of Governors and the FOMC .

During his time as a special adviser he helped spearhead the advent of the FOMC press conference, the Summary of Economic Projections, and the now infamous dot plot graph. He also was involved with the FOMC's official adoption of its 2 percent inflation target. Andy discusses these developments with me and how he would like to see them further refined.

We also discussed what happened in 2008. The economy was contracting and yet for much of the year the Fed was signalling it was worried about inflation and wanted to raise rates. Specifically, beginning around April 2008 the market expectation of where the federal funds rate would be 12 months ahead started rising. It rose all the way to about 3.5 percent by June 2008--the market was expecting the Fed to raise rates 150 basis points in mid-2008! Although it slowly came down, the fed fund futures rate 12-months ahead still remained higher than the actual federal funds rate through September. This can be seen in the figure below:

Andy notes that the FOMC transcripts reveal that even by the September 2008 meeting Fed officials were still not grasping the severity of the crisis. Why? We discuss whether they were simply too focused on inflation or whether insular thinking and group think prevented the Fed from appreciating the severity of the downturn during 2008.

We then moved on to Andy's proposed reforms. These have received coverage in the media and support from the 'Fed Up' campaign. Andy's reforms are driven by four key problems he finds with the Fed: (1) Regional Fed banks face a conflict of interest given their private ownership, (2) the process for choosing Fed officials is opaque and broken, (3) their is a lack of diversity at the Fed, (4) the Fed is shielded from public oversight. Andy's solutions to these problems are to (1) end commercial ownership of the regional Fed banks, (2) make Fed officials limited to a single, non-renewable 7-year term, (3) make all Fed employees public employees with a better representation of the American public, and (4) align transparency at the Fed with the standards of other public institutions.

We close the discussion by looking at Andy's research on the anchoring of inflation expectations, the need to do periodic evaluations of the Fed's objectives, and the question of why inflation has been persistently below target for the past five years. This was a thought-provoking conversation throughout.

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming.

Friday, September 30, 2016

The IMF reports in the latest WEO that the world has a low inflation problem:

By 2015, inflation rates in more than 85 percent of a broad sample of more than 120 economies were below long-term expectations, and about 20 percent were in deflation—that is, facing a fall in the aggregate price level for goods and services (Figure 3.2). While the recent decline in inflation coincided with a sharp drop in oil and other commodity prices, core inflation—which excludes the more volatile categories of food and energy prices—has remained below central bank targets for several consecutive years in most of the major advanced economies.

Here is the IMF's figure that nicely summarizes this development:

This figure shows this trend toward low inflation started around the time of the Great Recession and has only grown. Given its global nature, I am going to call this development the loflation pandemic. So what is behind it? Here is the IMF's explanation:

Economic slack and changes in commodity prices are the main drivers of lower inflation since the Great Recession.

The commodity story, in my view, is limited in how much it can explain since commodity prices have gone up and down since 2008. Moreover, as Jim Hamilton and Ben Bernanke argue, just under half of the commodity price decline since mid-2014 can be attributed to weak global demand. Weak commodity prices, in other words, are themselves partly the result of anemic demand.

That leaves economic slack, or insufficient nominal demand growth, as the main reason for the decline in global inflation. As I said before, nominal demand ain't what it used to be. This, though, begs the question as to why nominal demand growth been so weak? And why have advanced economies been so willing to tolerate it?

The IMF does not answer these questions. All it recommends is that governments do more with fiscal and monetary policy, complemented with structural policy. This is futile. One cannot expect to change government's behavior without first knowing why they are acting as they do.

Since the IMF seems unwilling to go there, I will. Governments in advanced economies have avoided robust aggregate demand growth--and therefore have created the loflation pandemic--because of the constraints created by their past successes with inflation targeting. Inflation targeting has become the poisoned chalice of macroeconomic policy:

Central banks have been so good at creating low inflation since the early 1990s that it is now the expected norm by the body politic. Any deviation from low inflation is simply intolerable. In the US, everyone from the media to politicians to the average person start to freak out if inflation heads north of 2%. This mentality seems even worse in Europe. Inflation-targeting central banks, in other words, have worked themselves into an inflation-targeting straitjacket that has removed the few degrees of freedom they had. It is hard to imagine Yellen and Draghi being able to raise inflation temporarily above 2% in this environment. All they can do is operate in the 1-2% inflation window. Inflation targeting's success has become it own worst enemy.

Another way of saying this is that the space for doing macro policy has shrunk to the small window of 1-2% inflation. Not only is monetary policy constrained by this, but so is fiscal policy...

For these reasons inflation targeting has become the poisoned chalice of macroeconomic policy. It was a much needed nominal anchor in the 1990s that helped restore monetary stability. Its limitations, however, have become very clear over the past decade and now is preventing the world from having the recovery it needs...

Put differently, no matter what the central banks try--QE, forward guidance, negative rates--they will never push beyond the public's expectation of low inflation. Fiscal policy, including helicopter drops, will also run up against this constraint.

If a trucker gets stuck in traffic jam, he will have to temporarily speed up afterwards to make up for lost time. On average, his speed for the trip will be the legal speed limit but only if he temporarily speeds up after the traffic jam. Likewise, an economy may need temporarily higher-than-normal inflation after a sharp recession to return to full employment. This also implies temporarily higher-than-normal nominal demand growth. On average, this temporary pickup will keep inflation and nominal demand growth on target. Running a little hot, therefore, is necessary sometimes. Currently, however, this policy flexibility is not possible.

This, in my view, is a key reason why the recovery from 2008-2009 was so weak. It is also why QE was set up to disappoint.

Inflation targeting was a much needed nominal anchor across the globe when it was first introduced in the early 1990s. But now it has put advanced economies into a low inflation straitjacket that is becoming a drag on economic growth. Until we recognize and act upon this observation, we can expect the loflation pandemic to spread.

Monday, September 26, 2016

My latest Macro Musings podcast is with Morgan Ricks. Morgan is a law professor at Vanderbilt University where he specializes in financial regulation. Between 2009 and 2010, he was a senior policy adviser at the U.S. Treasury Department where he dealt with financial stability initiatives and capital markets policies related to the financial crisis.

Before joining the Treasury Department, Morgan was a risk-arbitrage trader at Citadel Investment Group, a Chicago-based hedge fund. He previously served as a vice president in the investment banking division of Merrill Lynch & Co., where he specialized in strategic and capital-raising transactions for financial services companies.

A key point he makes in the book, and one that we discuss on the show, is that the standard definition of money is too narrow. Money, properly understood, should include both retail and institutional money assets. This is a point I have repeatedlymade on this blog and in various papers. Morgan, however, does a much better job articulating this point and his chapter two "Taking the Money Market Seriously" by itself make the book a great investment.

This understanding is important because it helps us better understand the financial crisis of 2007-2008. First, it helps us see that the institutional money assets were susceptible to a bank run just like retail money assets were before FDIC was introduced. The potential for a bank run with the institutional money assets came to fruition in 2007-2008. Second, this understanding also helps us see that the bank run caused a collapse in the broad money supply and that, in turn, helped bring about the sharp collapse in 2008-2009. Money still matters! It also, arguably, played a key role in anemic recovery that followed.

The collapse in the money supply can be seen in the figure below. It shows several broad measures of the money supply that include both retail and institutional money assets. The measures come from the Center for Financial Stability:

We go on to discuss his proposal for fixing the run-prone nature of the banking system, what it would mean for banking, how policy would operate, and more. Once again, another fascinating conversation throughout. And if you want further details read his book.

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming.

Wednesday, September 21, 2016

The Bank of Japan (BoJ) just launched a new phase in its monetary easing program popularly known as Abenomics. It is doing so in the hopes of shoring up economic growth. This monetary program until today had involved a targeted expansion of the monetary base at ¥80 trillion a year matched by ¥80 trillion in government bond acquisitions. There were also targeted purchases of ETFs and REITs on a smaller scale.1

The new phase unveiled today consist of three key developments. First, the BoJ will target the 10-year government bond interest rate at zero percent. Second, it will aim to overshoot its 2% inflation target so that it is truly symmetric. Third, it will drop its quantity target for the monetary base and simply make its expansion conditional on the inflation overshoot. Everything else in Abenomics remains roughly the same.

So has the Bank of Japan finally mastered its monetary conditions in a way that will spur economic growth? Or is this just another step into the quantitative quagmire of Abenomics? The short answer: do not get your hopes up. There are two reasons why this probably will not make much difference.

First, the BoJ is pegging the 10-year yield on government bonds at a level it would be at anyways. Because of slow global economic growth and continued uncertainty, yields on safe assets around the world have been falling since 2008. This race to the bottom for safe asset yields can be seen in the figure below:

Over the past eight years, this downward march of yields has occurred before, during, and after various QE programs. So while it is true that the BoJ has been the marginal buyer of Japanese government bonds over the last year, its actions are only doing what the global bond market was already doing and would have continued to do in the absence of BoJ actions. Put differently, the market-clearing or 'natural' interest rate that is based on fundamentals has been falling for some time and is already very low. The BoJ's new long-term interest rate target simply is a recognition of this fact. So there really is nothing new here.

Second, there is a serious credibility issue when it comes to the expansion of the Japan's monetary base. As seen in the figure below, the monetary base has seen a three-fold increase in its size since the beginning of Abenomics. If this expansion were truly permanent, then the price level would also increase threefold over the long-run. There is no way that can happen. The population is aging and depends increasingly on fixed income. Inflation for them is a non-starter. There is no political economy support for such a radical change in the price level.

Here is why this matters: some portion of the monetary base injection (above that needed for normal money demand growth) needs to be viewed as permanent in order for spending and inflation to rise. If monetary injections are expected to be temporary they would do little to spur spending. If they are viewed as permanent, however, they would raise the expected future price level and thus temporarily push up expected inflation. The higher expected inflation, in turn, would spur robust spending in the present. But this requires some portion of the monetary base growth to be seen as permanent.

The problem, though, is that the expansion of the monetary base has been so large there is no way this growth can be seen a permanent for fear of excessive inflation taking off. The BoJ wants 2% inflation with some overshoot. If the threefold increase of the monetary base were made permanent, the BoJ would get 300% inflation with overshoot! Put differently, the massive expansion of the BoJ's balance sheet undermines its very goal of raising nominal spending and inflation.

So making the growth of monetary base conditional on inflation hitting its target is not credible. The monetary base is simply too large for the BoJ to get any traction this way.

So Does Abenomics Matter?

With all that said, Abenomics has been able to spur some aggregate demand growth and some inflation. Just nowhere near where the government wants it to be. Below is a figure that shows the level of nominal spending (as measured by nominal GDP) for Japan. Nominal spending has grown under Abenomics, far more than under the origional QE program of 2001-2006:

I used to think this moderate success was because the monetary base expansion under Abenomics was permanent. But now that the monetary base has gotten so large, I am doubtful for the reasons laid out above. So Abenomics has been moderately successful, but it is not entirely clear to me why this is happening.

It is worth noting one of the goals of Prime Minister Shinzo Abe's government is to raise nominal GDP to ¥600 trillion by 2020. Yes, Japan has a NGDP level target. The Prime Minister first called for this goal in September 2015 and spoke to it again in December 2015. Since then, it has been in the government's economic and fiscal projections For example, here is the July 2016 executive summary of the projections. The nominal GDP goal stated near the top of the document.

When the goal was first introduced, it was an ambitious 20% growth goal for Japan's nominal GDP. It is now closer to 17% given the growth of nominal GDP since then, but this still remains a very ambitious goal as seen in the figure below. This figure shows different paths towards the ¥600 trillion by 2020.

All of these paths seem ambitious given the recent growth rate of nominal GDP in Japan. It is not clear how to get there without having a major overshoot of inflation. Maybe the BoJ could reiterate the governments nominal GDP level target and try to communicate that some small portion of the monetary base will be permanent and that it will be injected via purchases of perpetual government bonds. Admittedly, this would be a tough message to communicate. But it is not clear what alternatives there are for Japan.

So to answer the question in the title to this post, I suspect Japan may be heading further into a quantitative quagmire rather than mastering its monetary conditions.

P.S. Yes, the markets seem happy about this development so far. But they also seemed happy about the ECB's added stimulus in March 2016. That euphoria did not last and neither will this reaction to the BoJ.

1ETFs were and continue be purchased at annual rate of ¥9 trillion while REITs are purchased at a targeted rate of ¥60 billion.